Speaking of Bruce Berkowitz, he provided his investment checklist at the recent Columbia Investment Management Association conference which is worth considering:
- Can you kill the investment? Is there adult supervision at the company?
- Is the company essential? Does it depend upon the kindness of strangers?
- What can the company make? Reasonable profitability for owners?
- How are owners paid? Distributions?
- Management – honest in past and present?
- Does accounting reflect reality?
- Does the balance sheet match up with the income statement?
- Catalysts – Buybacks? Misunderstood? Is enterprise having a big problem that is fixable? Everyone’s been burned by the stock so afraid to buy it.
- Are there irrational fears of current headwinds?
- Does the business have pricing power or unit growth?
- Can you hold the investment for a long time & does it improve portfolio performance?
Attempting to extract some common themes from these questions, I’ve come up with the following:
- Survival (Q. 1, 2): How assured are you that the company will survive? It is appropriate that these questions come first, as a common theme among successful value investors is to focus on the downside first and let the upside take care of itself.
- Earnings (Q. 3, 4): What should investors reasonably expect the company to earn and what should investors expect to see of this? The addition of the word “reasonably” is important here, as a common mistake is to look at the most recent earnings and assume these will continue. A more reasonable analysis would include a consideration of the company’s earnings both in good times and bad, or normalized earnings over a business cycle. This allows the investor to avoid the mistake of investing at the peak, or failing to invest in the trough. Asking how much of the company’s earnings investors will see leads one to consider how shareholder friendly management is (repurchases or dividends) and how earnings differ from free cash flows over time.
- Integrity (Q. 5, 6, 7): Berkowitz devotes the greatest number of questions to the idea of management integrity, suggesting the importance of reading financial statements (even those “vetted” by the SEC and other regulatory bodies) with a skeptical eye, checking and double checking to avoid being fooled. (Read my review of Financial Shenanigans here to learn some of the red flags to watch for).
- Reputation (Q. 8, 9): Here Berkowitz inquires as to the nature of the discount. Is there an obvious reason the market is overly bearish on a particular stock? Do you agree with that reason? Is there evidence to suggest otherwise?
- Growth (Q. 10, 11): It is appropriate that growth is left to the end, as an added bonus that works in favour of an investment, rather than as the primary consideration and rationale for making the investment. However even value investors must consider growth prospects, as holding periods can stretch on as we wait for the market to focus on the fundamentals.
An Hour With Ben Graham
This interview took place on March 6 1976. At the time, a struggling insurer, Government Employees Insurance Company (GEICO) was making headlines as it teetered on the brink of bankruptcy. Ben Graham understood the opportunity GEICO offered, and that’s where the interview began. Ben Graham and his partners had, at one time, been significant shareholders Read More